Satyajit Das: For the Saudis, low oil prices are a means of exacting revenge

Das Capital: Up to 80 per cent of shale reserves are uneconomic at prices below $80 a barrel

The price of crude oil, adjusted for inflation, is at 1979 levels, having fallen by more than 40 per cent since June 2014. This is not the first oil price shock but a result of periodic conflicts in the oil market that John D Rockefeller, a century ago, called the “great sweating”.

Weak demand contributes perhaps 30-40 per cent of the fall. In 2014, oil demand grew by around 500,000 barrels a day, below the 1.3 million barrels growth projected earlier, reflecting weak economic activity in Europe, Japan and emerging markets, especially China.

Increased supply contributes 60-70 per cent of the decline. In a pattern reminiscent of earlier price cycles, several years of high prices and strong demand have encouraged new sources of oil supply to be brought on stream, causing the price to adjust. In the past three years, the US alone has added three million barrels a day of new supply to the world oil market – equivalent to the output of Kuwait or the United Arab Emirates.

The increased supply has been exacerbated by the refusal of Opec, led by Saudi Arabia, to cut output for strategic and geopolitical reasons. The market share of the oil producers’ cartel has fallen from over 50 per cent in 1974 to around 40 per cent. Compounding Opec’s problems are efforts to reduce oil intensity and decrease the role of oil as a transport fuel. The poor financial condition of some Opec members, which makes it hard for them to reduce production because of the need for oil revenues, aggravates the decline of the cartel’s power and its ability to dictate prices.

From the Saudi perspective, the primary benefit of high oil prices has accrued to non-Opec members. A cut in Saudi or Opec production to support prices would only further benefit these oil producers. The Saudis are mindful of history. In the mid-1980s, Saudi Arabia cut its outputs by close to 75 per cent to support weak prices. The Saudis suffered a loss of revenues and also market share. Other Opec members and non-Opec producers profited from higher prices. In recent years, Saudi Arabia has regained market share, benefiting from the disruption to suppliers such as Iran, Iraq and Libya. The Saudis are reluctant to cut production, preferring to maintain market share rather than prices.

The strategy is to allow prices to fall to levels below the production costs of high-cost producers and non-traditional oil sources. The average break-even cost at present is probably between $60 and $70 a barrel. Importantly, US shale oil may not be economic below those price levels. Perhaps as much as 80 per cent of shale reserves are uneconomic at prices below $80 a barrel, at least based on current technology.

In the short run, producers may continue to produce and sell at below full-costed break-even prices. If oil prices stay low for a sustained period, producers will be forced to cut production – and marginal or higher-cost firms will have to close or declare bankruptcy. Most importantly, irrespective of production level changes, expansion and new investment will be low and eventually be wound back.

For example, oil prices above $100 a barrel would allow deep-water reserves, arctic oil, tar sands or shale deposits in countries such as Canada, Poland, Argentina and Venezuela to be profitably developed. Lower prices would make these uneconomic. The lack of investment capital will ultimately reduce immediate supply and the potential resources for future production worldwide.

In theory, Saudi Arabia’s oil and foreign policies are separate. In practice, they are related. The oil price shocks of the 1970s were, in part, a response to Western support for Israel and the Arab humiliation in the Six-day War.

Low oil prices hurt Iran, Saudi Arabia’s competitor for political influence in the Middle East. They are revenge for Iran’s support of the Shia factions in Iraq, its allegiance to the Syrian leader Bashar al-Assad and its destabilising nuclear programme. Low oil prices hurt Russia too, which also supports Syria and Iran. And they undermine the financial basis of Isis militants, whose sales of cheap smuggled oil funds their military activities.

Low oil prices can also be seen through a Saudi prism as a reprisal against the US. They undermine American attempts at greater energy self-sufficiency through exploiting its shale gas and liquid resources. And they are a means of exacting revenge for America’s strategic rebalancing away from the region to a greater Asian focus.

The oil strategy is a signal from Saudi Arabia that it wields significant power and should not to be treated casually in geo-political terms.

Satyajit Das is a former banker and author of ‘Extreme Money’ and ‘Traders, Guns & Money’